The primary subject matter of this case explores expectations
regarding short-term liquidity across different industries. Secondary
issues examined include working capital management and signals of
working capital efficiencies. The case requires students to interpret
varying working capital and liquidity ratio levels across companies.
This case has a difficulty level of two, three, or five; the case is
appropriate for financial accounting principles, introductory financial
management, intermediate accounting, and introductory financial
accounting for MBAs. This case is designed to be taught in one hour of
class time and is expected to require one hour of outside preparation by
students.

CASE SYNOPSIS

Using data from Bon Ton Stores, TJX Companies, Wal-Mart Stores,
Brinker International (Chili's) and Southwest Airlines, students
learn about basic liquidity analysis. Students will observe significant
differences in key liquidity metrics both within and across industries.
Students will consider the overall liquidity positions of the firms by
comparing their working capital levels and their current ratios.
Students will identify the driver of the differences in the current and
quick ratios, and will explore issues in managing working capital. In
the process, they will uncover some surprising findings. Some
working-capital metrics may look good while hiding deficiencies that can
be revealed by further analysis. Similarly, working-capital metrics may
look bad, but further digging uncovers efficiencies. The case also
highlights the interesting tension that exists between a lender's
perspective about liquidity (more is better) versus a company's
desire to increase profitability, which necessitates efficiently
managing its working capital.

INSTRUCTORS' NOTES

Recommendations for Teaching Approaches

The case features non-manufacturing firms since these are typically
the focus of introductory accounting courses. The case can be used at
the undergraduate level in introductory financial accounting or when
discussing liquidity analysis in intermediate accounting. The case can
also be used early in an introductory financial accounting class for
MBAs.

The case could be assigned after having briefly discussed the basic
liquidity metrics during a class meeting or after having assigned a
relevant reading from a textbook. Students should be familiar with
accounting for accounts receivable, inventory, prepaid expenses,
accounts payable, and unearned revenue. Students should be able to
distinguish current assets from long-term assets and current liabilities
from long-term liabilities (elements of a classified balance sheet).

Instructors can proceed through the six case questions in numerical
order or alter the sequence. However, the last question builds on
answers to some of the earlier questions. Depending on the course level,
time constraints, or topic preferences, instructors can also eliminate
questions. An extension to this case is presented at the conclusion of
these instructors' notes. It can be used to introduce students to
the ratio of operating cash flow to average current liabilities, a
lesser known, but useful short-term-liquidity metric. The instructor can
direct students to the SEC's EDGAR website to gather data necessary
to see how seven identified pairs of peer retailers fared when measured
on this metric vis-a-vis the current ratio.

To facilitate answering the questions, the financial data contained
in Table 1 of the case are repeated below. Balance sheet data are as of
year-end unless labeled as an average for the year.

QUESTIONS FOR DISCUSSION (WITH SUGGESTED ANSWERS)

1. Despite having $363 million of working capital at F2010 year-end
and a 1.88 current ratio that is the highest among the Table 1 firms,
Bon Ton was included in a Forbes list of 10 retailers flirting with
trouble (Hawkins, 2010). Which data in Table 1 suggest that this
retailer's liquidity position was not as favorable as it initially
seemed?

Because the current ratio and the working capital amount can create
an illusion of favorable liquidity when none may exist, many analysts
also calculate the quick ratio. As seen in Table 1, Bon Ton's quick
ratio was the lowest among the five firms. The firm went from having the
highest current ratio to the lowest quick ratio because 88% of its
current assets are tied up in inventory. Perhaps its impressive working
capital amount results from the retailer having difficulty in selling
its inventories. In comparison, inventory represented 54% and 70% of
current assets for TJX and Wal-Mart, respectively.

2. Which ratios could help an analyst appraise the liquidity of Bon
Ton's inventory as compared to that for TJX and Wal-Mart? Explain
whether relatively high or low values on these metrics would suggest
less liquidity risk.

An analyst could compare the three firms' inventory turnover
ratios (cost of goods sold divided by average inventory). Inventory
turnover indicates the number of times during the period that a firm
sells its average balance of inventory. The higher the inventory
turnover ratio, the lower the liquidity risk. Similarly, the analyst
could compare the average days in inventory, also known as the
days' sales in inventory, (365 days divided by the inventory
turnover). The lower the average days in inventory, the lower the
liquidity risk because inventory is held for a shorter period of time.
The current ratio is thus a more accurate indicator of liquidity if a
firm has a low average days in inventory. Alternatively, an analyst is
likely to place less reliance on the current ratio and more reliance on
the quick ratio for firms with slow-moving inventory.

As seen in Table 2, it takes Bon Ton 132 days to sell its average
balance of inventory which, respectively, is 72 and 92 days longer than
it takes TJX and Wal-Mart. It takes Wal-Mart less than a month and
one-half to sell its average balance of inventory. Some of this
difference is due to the different composition of merchandise
inventories between Wal-Mart and the two other firms. Analysts would
expect that Wal-Mart's inventory turnover would exceed Bon
Ton's because Wal-Mart sells many food products. However, as is the
case for Bon Ton, TJX does not stock food products and yet its inventory
turnover is more than twice that of Bon Ton's.

Wal-Mart also uses technology and its power within its supply chain
to achieve efficiencies that minimize the amount of inventory it
carries. Wal-Mart maintains tight inventory control through its
supply-chain management. Given its economic muscle, Wal-Mart achieves
many concessions that transfer risk from Wal-Mart to its suppliers.
Wal-Mart accelerates delivery times, getting suppliers to replenish
inventory frequently. Some speculate that Wal-Mart will eventually use
its technology for scan-based trading, in which manufacturers own each
product until Wal-Mart sells the item (Hays, 2004). This would further
lower reported inventories on Wal-Mart's balance sheet.

3. What contributed to Wal-Mart's negative working capital of
$6.6 billion and how can a firm survive, let alone thrive, with such an
excess of current liabilities over current assets?

As noted above, Wal-Mart has taken the lead among retailers in
achieving inventory efficiencies. At the same time, it has used its
power over suppliers to increase its days' purchases in accounts
payable. This combination of better inventory management and accounts
payable stretching has allowed the firm to simultaneously reduce a major
current asset while increasing a major current liability. The combined
reductions in its working-capital investment that Wal-Mart achieved
through carrying less inventory and taking longer to pay suppliers was
measured in a 2005 study. It was estimated there that Wal-Mart achieved
a 117% reduction in its working-capital amount over the 1995 to 2003
period by reducing its days' sales in inventory and increasing its
days' purchases in accounts payable compared to their 1995 levels
(Gosman and Kohlbeck, 2005). The study reported that Wal-Mart's
2003 working capital of a negative $2.4 billion would have been a
positive $14.0 billion had it not achieved efficiencies over that 8-year
period.

A firm can survive with little or no working capital as long as it
has large, steady inflows of cash from operations. As seen in Table 1,
Wal-Mart's cash from operations exceeded $23 billion in Fiscal
2010.

4. Explain why it is not surprising that the two Table 1 firms with
the smallest differences between their current ratios and quick ratios
are Brinker and Southwest Airlines.

Current and quick ratios differ significantly from each other only
when a sizable portion of the firm's current assets are in the form
of inventories. Restaurant businesses and airlines require relatively
low inventory as compared to retail department stores such as Bon Ton,
TJX, and Wal-Mart. Restaurants maintain low inventory because food items
are perishable. Airlines have always had low inventory levels and with
their reduced food offerings on flights, you could say that it now
"amounts to peanuts."

5. How might the composition of current liabilities at Southwest
Airlines contribute to low current and quick ratios?

Southwest Airlines has a significant current liability in the form
of unearned ticket revenue from customers paying in advance of flights.
This liability will be satisfied as the customers fly (i.e., when the
service is provided). While these obligations increase current
liabilities in the denominator of both the current and quick ratios,
they will not require significant incremental cash for settlement of the
obligation. All other things being equal, the presence of sizable
unearned revenue means that current and quick ratios can be expected to
be lower and still be adequate.

6. Summarize factors that should affect one's assessment of
the adequacy of a firm's investment in working capital and the
level of its liquidity ratios.

(1) The extent to which the line of business does not require large
inventories.

Airlines and restaurants carry less inventory than department
stores, and thus they would be sufficiently liquid with a lower current
ratio than department stores would require. In fact, in light of these
firms' insignificant inventory amounts, the adequacy of their
current ratios is best judged by examining desired threshold levels for
quick ratios.

(2) Receivable and payable management (the speed of the cash
cycle).

The operating cycle is the sum of the average days in inventory and
the average collection period. In general, the shorter the operating
cycle, the lower the necessary investment in working capital. By
minimizing the number of days a firm holds inventory until sale and/or
by quickly converting sales into cash, a firm can be liquid with less
working capital.

The longer that a firm is able to stretch its payables, the lower
the minimum investment needed in working capital. For example, if a firm
sold goods in 40 days like Wal-Mart does and had very few accounts
receivable, then so long as it could negotiate credit terms from its
suppliers that were not far from 40 days, there would be less need for
alternate sources of financing in order to pay suppliers for the
inventory purchases. Their customers, in effect, could be paying their
suppliers. This creates working capital efficiencies, minimizing the
level of working capital needed in order to satisfy short-term
obligations as they become due.

Bon Ton suffers here relative to Wal-Mart because Bon Ton is taking
92 more days to sell its inventory. In addition, it is not in as strong
a position to negotiate longer payment terms with its suppliers. Thus,
Bon Ton has a much greater need to look for other sources to finance its
purchases of inventory, whereas Wal-Mart can essentially delay paying
suppliers until close to when it has collected cash from the sale of
that inventory to customers! Increasing the speed of a cash cycle
through inventory and accounts payable management allows firms to carry
less working capital.

(3) The extent to which the firm's current liabilities do not
require significant incremental cash outflows.

Like Southwest Airlines, any business that typically receives
significant amounts of cash in advance for future goods or services
should have lower thresholds for adequate working-capital levels and
current and quick ratios. Examples would include newspaper and magazine
publishers, theater groups, and cruise lines.

Extension

Instructors who wish to consider how Bon Ton would compare to TJX
and Wal-Mart on an alternative liquidity measure could introduce the
ratio of operating cash flows to current liabilities, calculated as
follows:

This ratio recognizes that successful firms do not liquidate their
current assets to pay their current liabilities, but instead use
operating cash flow for that purpose. Some research suggests that a
level of 40% or higher on this ratio often presents itself for a healthy
retailer (Casey and Bartczak, 1984).

Operating cash and average current liabilities are from Table 1.
Interestingly, as shown in Table 3, both TJX and Wal-Mart are above 40%
on this financial measure and Bon Ton, the firm with the highest current
ratio, was below 40%.

Instructors who wish to pursue this point further could direct
students to the SEC's EDGAR database to gather data necessary to
make the following comparisons for peer retailers:

For the first five comparisons included in Table 4, the retailer
with the higher (often much higher) current ratio had the lower (often
much lower) ratio of operating cash flow to current liabilities. And
three of the retailers with impressive current ratios--Zale, Rite Aid,
and Conn's--were, like Bon Ton, included in a Forbes list of 10
retailers flirting with trouble (Hawkins, 2010). In the sixth pairing,
two supermarkets with practically identical current ratios had,
nevertheless, dramatically different ratios of operating cash flow to
current liabilities. In the last comparison, Staples' edge over
Office Depot in terms of the current ratio understated the magnitude of
the former's advantage on the operating-cash-to-current-liabilities
metric.

Given that current liabilities are more likely to be paid out of
operating cash flow than current assets, the current ratio provides only
partial insight into retailers' ability to meet their short-term
obligations. In four of the seven pairings shown in the above table,
retailers that seemed to be awash in liquidity--as measured by a current
ratio of 1.82 or higher--were seen in a much different light when
measured by their ratios of operating cash to current liabilities, which
ranged from -15% to +18%. Clearly the ratio of operating cash flow to
current liabilities should represent an additional arrow in the quiver
of the analyst as he/she assesses a firm's ability to meet its
short-term obligations.